Large Currency Blocs Needed for Stable Development, Nobel Laureate Urges
Nobel economist Robert A. Mundell tells UCLA audience small countries suffer from floating exchange rates and should tie their currencies to the dollar.
Published: Wednesday, May 01, 2002
“Fix the currency to the dollar, then Mexico would get the inflation rate of the United States. This could give them years of stable currency.”
Robert A. Mundell, winner of the Nobel Prize in Economics in 1999 and a professor at Columbia University, spoke at UCLA April 25, where he strongly urged the creation of large international blocs sharing the same currency, such as the euro, as a key means to promote economic development and stability for smaller countries.
Advantages of the Euro
“Now that they have achieved a unified currency, which will be complete in June of this year,” Mundell said of the participating states in the European Union, “the 12 countries of the euro area now will have solved their macroeconomic stabilization policies. Every single country has a better monetary policy than they did before. Their capital markets are far larger. Their new currency is the second largest in the world compared with the previous small local currencies. Fixing the exchange rates as they did in 1998 and the adoption of the euro in 1999 eliminated speculative capital movements. Ten years ago Portugal, Spain, Italy, and Greece had high interest rates due to speculation. This is stable now.”
Mundell was the featured speaker at the Sixth Annual Arnold C. Harberger Distinguished Lecture on Economic Development, sponsored by the Ronald W. Burkle Center for International Relations.
Imagine Two World Currency Maps
Mundell said that monetary policy was greatly underestimated as a contributor to economic development. An isolated small country has less access to capital and is subject to currency speculations that can gravely disrupt its economy. He asked the audience to visualize two alternative currency maps of the world. In one, each of 200 separate countries has a unique currency represented by 200 uniform circles. “There would be 15,000 exchange rates among the 200 countries. This would precipitate a search for some common standard that could create a fixed exchange rate.”
The alternative currency map is of today’s actual world. In this map, one large circle, representing the United States and its dollar economy, stands for 25% of the total space, with a U.S. Gross Domestic Product of $10.5-11 trillion. “The creation of the euro in 1999 became instantly the number 2 international currency after the dollar, with the yen third.” The GDP of the euro area is about US$6 trillion, and of the yen area, about US$4 trillion. The British pound sterling area is about $1.5 trillion. The Chinese renminbi represents an economy with a GDP of about $1.2 trillion. “If Britain joins the euro area it will be proportionately larger still. There are also a group of countries in Africa that are now tied to the euro. Denmark and Sweden opted out, but may come in in the future.” Many other countries on the actual map “would be only little points.”
There are tremendous benefits to belonging to a large currency circle on the map. “Each of these currency areas are to a degree a common economy. In each currency circle there is a unified capital market.”
Previous Monetary Standards
At root, Mundell said, is the need for a dependable and predictable standard for currency exchange. “This was the role played by the gold standard, and previously by the bimetallic standard, gold and silver. The genius of bimetallism was that countries on the gold standard and countries on the silver standard could exchange at the same rates. And it worked without any need for common political relations.” The United States went off bimetallism during the Civil War. Later the rich countries adopted the gold standard, which the poor countries eventually reluctantly followed. “This broke down in World War I. It was restored but not very successfully afterwards.”
Speculative Pressures on Small, Isolated Currency Systems
Americans, Mundell pointed out, don’t feel pressured to have a world currency because U.S. output is 25 percent of world total. This is a huge area. “But residents of small countries find that the price level is the same as the exchange rate. In the larger countries, the domestic zone gets bigger and the exchange rate has less influence.”
“What is Bill Gates worth?” he asked. “Maybe $70 billion. With his own money he could buy up the currency of, say, 50 countries in the world. Suppose the currency map had 200 equal circles instead of one giant 25% circle. You can see the potential effects of even single large corporations in affecting the stability of small systems.”
Flexible Exchange Rates and Inflation Targeting
After the final abandonment of the gold standard in the 1970s the world entered a system of flexible exchange rates. “Its goal was to have monetary stability, but it does not give that. To be stable you need a standard. One way if you are a small country is to link your currency to that of a large and relatively stable currency such as the dollar. But flexible rates is the absence of a monetary rule. Adopting it was a mistake.”
The United States in the post-gold standard period has sought currency stability through inflation targeting: “You try to keep the same rate of inflation. Inflation targeting, exchange rate targeting, these are possible realistic choices. The U.S. can’t fix its currency to a little currency. It has to use inflation targeting. The euro also uses inflation targeting. They try to keep inflation stable."
The Case of Mexico
Mexico from 1954 to 1976 had a fixed exchange rate with the U.S. “This gave it a stable currency that moved with the U.S. dollar. From 1976 to 1992 they floated and had very high levels of inflation. High monetary instability. And this was despite the discovery of oil and the great increase of oil money in the economy. Mexico went deep into debt and helped trigger the international debt crisis. This was typical of 100 other countries that are in just as bad shape.” In 1994 Mexico stabilized around 3.5 pesos to the dollar. Later on the dollar went to 10 to the peso, to Mexico's great disadvantage.
Today the peso is about 9 to the dollar. “Mexico has shifted to inflation targeting. Canada, the United States, and Europe are also pursuing a policy of inflation targeting, but these countries had low inflation so they had static inflation targeting, just to keep inflation at the same point. Mexico had an additional problem of high inflation. It had an inflation rate of 10 percent and wants to do dynamic inflation targeting, lowering the inflation rate each year, getting it down to 9, then 8, then 7. This requires tight money. Now it is down to 4.5 -5 percent, through a deliberate overvaluation of the peso.” Now that inflation is under control, Mundell said, the overvalued peso will have to be devalued to avoid a new crisis.
“What Mexico should do—and this is the same for a wide group of countries—is fix the exchange rate at the equilibrium rate, undervalued rather than overvalued. Make that the monetary rule. Then stop the inflation targeting. Fix the currency to the dollar, then Mexico would get the inflation rate of the United States. This could give them years of stable currency.” There is, however, a further requirement: “But there must be a balanced budget. You can't do this with an unbalanced budget. If you run up the public debt it will make for inflation. You have to have an administration in favor of the policy. This includes the minister of the central bank, the president, the top officials all have to agree on this policy.”
Mundell pointed out that nothing short of a single world standard of convertibility such as gold or a single currency standard can completely avoid currency fluctuations. His proposal to fix that is the adoption of dollar convertibility at a fixed rate for all major currencies. “If Mexico chooses the dollar, the peso will vary against the euro and the yen. There is a good case to link the dollar and the euro on a fixed basis.” He felt that the Pacific area could be the pace setter in such a trend. “You have the U.S. area, then you have China, which is fixed to the U.S. dollar, as is Hong Kong. The Malaysian ringgit is also fixed to the dollar. If you fixed the yen-dollar rate you'd have the whole Pacific area as a dollarized area and a platform for an APEC currency. I spoke at the last APEC meeting, right after President Bush. Jiang Zemin, Putin, Bush, Fox, Chretien of Canada, Megawati of Indonesia. If the yen went, South Korea and Taiwan would probably follow. Maybe even the Russians, on the grounds of aligning their currency with the APEC area. That would make it easier for the Europeans to follow. Then we could have a stable international currency as we had in the past. Perhaps even a world currency.”
The Effect of the Absence of a Currency Standard on the Post-Communist Transition
At the end of World War Two there were still fixed exchange rates and this helped in the reconstruction of Europe and Asia. “But at the end of the Cold War this did not exist," Mundell said. “What currency area could the former Soviet Union enter? Exchange rates were floating. All that existed were the international agencies—the IMF, World Bank, and etc. This was not enough. Output in all of these countries went down some 50%. Now 10 years later only a handful of these countries have gotten back to where they were at the beginning of the transition. Many of them faced terrible inflation. There was a great collapse of output. There was no stable currency to link to. The public sector stopped production, without taking off the rules that prevented the private sector from taking up the slack. The same is true in Latin America, which had strong statist tendencies.”
Robert A. Mundell has taught at Columbia University since 1974, and has served as an advisor to the United Nations, the International Monetary Fund, the World Bank, the European Commission, and several governments in Latin America and Europe.